Some of North America’s largest funds – including British Columbia Investment Management Company, CalPERS and Maryland State –  are ramping up their allocations to private markets, building in-house talent to take advantage of private equity and co-investment deals.

Major North American funds are increasing their allocations to private markets and, in particular, private equity, citing superior returns and the ability to exert control through co-investment. However bringing on board the requisite skillsets and resources has proved a challenge.

The British Colombia Investment Management Corporation has substantially increased its allocation to private markets in recent years, from 20 per cent in 2015 to around 45 per cent currently, with a target over the next three to five years of around 55 per cent, said Samir Ben Tekaya, head of investment risk at BCI, speaking in a panel discussing the experience of funds investing in private markets.

Out of this 45 per cent, 20 per cent is in real estate and 10 per cent is equally in private equity and infrastructure, with an increasing allocation to private debt. The fund ensures its allocation to fixed income is in highly liquid assets to offset the lower liquidity of private assets.

Speaking at Top1000funds’ Fiduciary Investors Symposium held between May 23-25 at the Chicago Booth School of Business, Ben Tekaya pointed to the diversification benefits from asset classes like real estate, infrastructure and private debt that provide stable incomes. But private equity is an attractive return in addition, he said, offering a substantial premium over public equities.

A focus on co-investing gives the fund the opportunity to access markets where there are less players, and also to exert some control over the amount of leverage in the company and participate in the value creation of those deals.

However co-investing and taking an active role is resources intensive, involving sourcing deals, monitoring those deals and attending a lot of board meetings of different companies in the portfolio, Ben Tekaya said.

“So this is, capacity-wise, something that particularly if you want to have active role on the private market, that’s something that we need to consider,” Ben Tekaya said.

Direct investing or co-investing also requires the fund to have capacity to inject cash from time to time, making these investments less predictable than more passive investments, he said.

“As we have seen during Covid, some of our portfolio companies needed some cash injection and we need to plan for that,” he said.

CalPERS–the biggest pension fund in the United States–just finished a year-plus asset liability management process of “working through liabilities and seeing what we’re trying to earn to meet those liabilities,” said Dan Bienvenue, deputy chief investment officer at CalPERS. This process then flows into strategic asset allocation.

As a result, the fund raised its 21 per cent allocation to private markets to 33 per cent, which included a 13 per cent allocation to private equity, 15 per cent allocation to real assets and a 5 per cent allocation to private debt.

Private assets are a very attractive asset class for their return per unit of risk, Bienvenue said, noting CalPERS had been under-allocated to private assets relative to its peers.

“For us, the critical part is when you’re a plan our size…we we need to do things that allow us to really move the needle at the portfolio level,” Bienvenue said.

Co-investment vehicles in particular enable the fund to take advantage of its scale, and building the requisite skills is a strong focus at present.

“There are a lot of organisations that can write 20 and 50 million dollar checks,” Bienvenue said. “There aren’t too many that can write 500 million dollar checks and we want to be on that short list of phone calls for situations like that.”

More than 30 per cent of the portfolio at Maryland State Retirement and Pension System is allocated to private assets, and more if you count hedge funds, said Andrew Palmer, the fund’s chief investment officer (pictured).

By investing in private markets, Maryland seeks to harvest an illiquidity premium, some skill-based alpha, and in some cases beta that can’t be obtained in public markets.

“We also think it provides a fair amount of diversification in the in the private equity world,” he said. “We just think it gives us a wider opportunity set for investing.”

Maryland also likes the “volatility dampening nature” of the way private assets are priced, Palmer said, as Maryland is a mature plan that pays out two or three percent of assets, and so doesn’t like drawdowns.

“To the extent we can have volatility muted, even through an artificial thing like quarterly pricing and estimated pricing, that’s actually something of value,” Palmer said.

The fund does modelling of periods of stress to figure out how much liquidity risk it can take, and its current allocation to private markets takes it “pretty close” to the limit, he said.

Palmer said the fund’s US private equity, European private equity and Asian private equity have had relatively similar returns over the last 10 years.

“They pretty much hit the return targets on the private equity space, and outperformed the public market space by hundreds of basis points, almost 1000 basis points,” Palmer said. “And so that really reduces my risk if I have confidence that I have assets that can generate those types of returns on a regular basis.”

Private equity investments are consistently beating the S&P 500 with beta that is “less than you think,” according to one of the world’s leading academics on private equity, Professor Steve Kaplan.

The average private equity buyout fund has beaten the S&P 500 every year since 1993, according to Steve Kaplan, a renowned expert on private equity at the University of Chicago Booth.

Beta is also lower than many investors realise, Kaplan said, arguing private equity returns don’t need to beat public equity returns by much to justify their poorer liquidity.

“There is not one vintage year where the average is below the S&P 500, so that’s pretty stunning,” Kaplan said of data he presented on private equity returns, speaking at Top1000funds’s Fiduciary Investors Symposium held at the Chicago Booth School of Business.

“I’ve just been shocked, you know, every year I would say it’s too much money, they’re going to underperform, and every year I’ve been wrong. So guess what? I don’t say that anymore.”

Kaplan is the Nebauer Family Distinguished Service Professor of Entrepreneurship and Finance, and Kessenich E.P. Faculty Director at the Polsky Center for Entrepreneurship at the University of Chicago Booth.

The beta of private equity is also “less than you think,” he said to an audience of institutional investors, pointing to modelling by Greg Brown from the Kenan Institute of Private Enterprise, which found the beta for buyout funds was typically just a little above one. This sounds counterintuitive for many investors, he said.

“First of all, the companies they buy aren’t necessarily as high beta as your typical company,” Kaplan said. “And second of all, when they do add value to their companies, that value added basically has zero beta.”

He noted that looking at historical results, “if you thought that buyouts were very high beta, then there’s no way the funds raised in ’05, ’06, ’07 should have performed as well as the S&P 500.”

Large buy-outs and venture also give “pretty significant diversification benefits relative to public equities,” Kaplan said, noting buy-out funds have sometimes outperformed when public equity is in decline, such as during the tech-wreck of 1999 and 2000.

“Looking backward, buyout has been an unbelievably good place to be both in terms of say alpha and in terms of diversification,” Kaplan said. “Venture has been mixed, but on average pretty good. Going forward, you know, that’s where it’s a lot harder to say.”

Interviewer Stephen Kotkin, an American historian, academic and author, asked how much above public equities the performance of private equity needs to be for institutional investors to see benefit, given these are private markets with lower liquidity than public markets, and given the complexity of measuring risk.

Kaplan said funds where private equity makes up only, say, 20 per cent of their portfolio “don’t necessarily need the liquidity anytime soon,” and so beating the market over a long period of time will be sufficient to make some players happy.

The secondary market had also come a long way in recent years, he said, “and you can actually get out at decent valuations.”

“I don’t think you need a ton of excess return to to justify it,” Kaplan said. “That’s why all the money is coming in. And when more and more money comes in, that creates the question, what’s going to happen going forward?”

Kotkin asked if the rise of data-driven investing could lead private equity to lose its sheen because “everyone is jumping on the same bandwagon.”

Kaplan said historically, those why try to time the buyout or venture markets based on the amount of money flowing into private equity are adopting a losing strategy when it comes to venture funds.

Taking for example a rolling tally of money raised over three years, if a fund saw a lot of money flowing into private equity in 1994, 1995 and 1996, then went underweight on venture funds in 1996 as a response, “you missed out on six times your money,” Kaplan said.

By the time 1999 arrived when a fund would actually have wanted to be underweight, this wouldn’t make up for the missed gains from being underweight in 1996.

Conversely, this strategy can be “a little bit of a winner” in buyout funds, but the gains aren’t very significant.

“Said another way, whatever strategy you did in private equity, you still beat the S&P 500,” Kaplan said. “It’s just really hard to time the market.”

Building the expertise for direct investment in global real estate and infrastructure is a priority for the new CIO of the United States’ largest pension fund. Nicole Musicco spoke to Amanda White in an exclusive interview at the Fiduciary Investors Symposium.

The new chief investment officer of CalPERS – the biggest pension fund in the United States – sees “a tremendous amount of low-hanging fruit” to be gained by greater private market allocations and diversifying the fund’s global investments.

Noting a relatively low allocation to private markets and to markets outside the United States compared to other funds of its size, CalPERS’ new CIO Nicole Musicco said building global strategic partnerships for co-investment deals in real estate and infrastructure would be a long-term priority.

Musicco was speaking at Top1000funds.com’s Fiduciary Investors Symposium at the Chicago Booth School of Business, in an exclusive interview with Amanda white, director of institutional content and the publication’s editor. Musicco is only two months into the job at CalPERS, which has around $500 billion under management.

“Certainly for the size that CalPERS is, we have ample opportunity to be leaning more into the private markets space,” Musicco said.

But Musicco, a Canadian, said building a direct investing program is not something to take lightly based on her first hand experience overseeing private equity at the Ontario Teachers’ Pension Plan. Building the expertise required “takes a good decade”, and CalPERS would continue relying on fund managers for the foreseeable future as she took stock of existing in-house expertise and looked to leverage a growing skill base across across different asset classes.

CalPERS last year increased its allocation to private equity, added a private debt allocation and approved leverage for the first time in the fund. Building the technology and data strategy required to facilitate nimble decision-making in such a large fund would be crucial, Musicco said.

“As soon as you’re going to start putting it out there that you’re ready to do more co-investing or direct investing, you know, partners expect you to be able to respond in an efficient manner, and if you don’t then you lose credibility and those calls stop coming in,” she said.

White asked about how she was viewing global macro risks–in particular inflation–and where she planned to take more active risk in the portfolio.

Musicco said she is preparing for her first investment committee meeting in June, and will be seeking to build a portfolio for resiliency in difficult market conditions, balancing the current exposure to equities with bringing more diversification into the program.

The correlation between bonds and equities is “much tricker” than in the past with fixed income not providing the “shock absorption” it traditionally has, Musicco said, leading her to look at other potential sources of active risk in private markets.

One potential low-hanging fruit is the fund’s relatively low amount of exposure outside the United States, she said, and here she saw an opportunity to build global diversification across asset classes.

There may also be opportunities to “turn up the heat a bit on active risk on the equity side,” Musicco said. Sub-sectors of real estate and infrastructure could add to both the liquid and illiquid parts of the program, she said.

With CalPERS famous for its engagement with companies on areas of ESG, Musicco said she had big shoes to fill on issues of diversity, equity and inclusion–known as the DEI movement–and ensuring CalPERS is a healthy and vibrant workplace. DEI is particularly important to her along with the path towards net zero emissions, she said, and she will be making sure analysis in these areas will be integrated with the fund’s risk analytics.

“Having DEI as one of those key pillars and areas of focus from the top of the house down in an organisation is super important,” Musicco said, noting this should be viewed through the “investing lens as well as the risk lens.”

“I’m making sure we have diversity in our decision-making, and then, through the investing lens, I do think that there needs to be a bigger push into…making sure any unconscious biases are really looked at when we’re looking at making investment decisions, for example, and to third-party managers.

“That we are, you know, acutely aware in our measuring the progress that we are making on investing behind the deep diversity and inclusion type framework. Those sound like easy things to do, but they’re not. I think organisations need to really make a commitment to be measuring progress along the way and reporting that progress.”

Raghuram G. Rajan, Professor of Finance, University of Chicago Booth School of Business and former Governor of the Reserve Bank of India, gave delegates at the Fiduciary Investors Symposium, held at the business school, encouragement that the Federal Reserve does have inflation under control.

Rajan argued that central banks are most concerned about inflation getting entrenched in everyday products. From here it can bleed into salaries and is hard to bring down. However, he said the five year, five year-forward rate for inflation, a bellwether of future inflation rates, suggests inflation will come down and that it is contained.

“There is a sense the Fed has it under control,” he said.

Wage agreements will push costs further for companies, creating another reason for companies  to raise prices. However he said the Fed will continue raising rates at the short end and shrink its balance sheet at the long end. The heat will come off the labour market and he predicted the job to unemployment ratio will start to come down. Elsewhere, demand will begin to fall and he said supply chains will not be snagged for ever.

In defence of the Fed, Rajan said that policy makers have acted with aggression. They didn’t act earlier for political reasons. The Fed wasn’t hitting its inflation target, and once inflation started to appear, it didn’t want to kill it: the Fed only acted when inflation was sustained and above its target, he said.

tight labour market

Reflecting on the tight labour market, he noted that during the pandemic participation rates fell. However, people have now come back into the work force in every group in the US except the over 64s. He said companies are facing a skills mismatch whereby the most acute labour shortages are tied to particular sectors and regions, but he said the primary tightening force is the slow down in immigration. Positively, maximum unemployment levels are only inclusive at the end of the cyle: minorities are typically hired at the end of the cycle.

He said wages are starting to increase and inflation is now moving from goods to labour markets in an inflationary process also stoked by war in Ukraine, with the crisis in Ukraine putting supply chains under further pressure and fuelling commodity prices. He noted how war in Ukraine and the lockdown in China will also have a stagflationary impact, slowing growth but also increasing inflation. Still, he noted differences between regions. For example, the labour market is not as tight in Europe; Japan still has very low inflation.

What lies ahead

Rajan said the effect of recent central bank policy is already beginning to emerge. The rise in the dollar has begun to impact exports; he noted the loss of wealth in financial markets, particularly hitting crypto and games stocks.

He said as more is spent on fuel, less will be spent on other goods and services, slowing down consumption.

“As things slow down most people tighten their budget.” However, he doesn’t believe economies are heading for a recession, and said recession is unlikely in the near term.

He reassured that banks are well capitalised across the world. However he flagged that in the shadow financial world, it is less clear which new finance companies have leverage and risky exposure.

Rajan said that the underpinnings of growth have not changed. For sure, falling levels of immigration and deglobalisation will continue to have a negative impact on growth, but he expects the economy to return to pre-pandemic, albeit slow, levels of growth.

He said the Fed has done enough for its policies to start to bite and policy makers will be in a much better position to gage the impact of strategy at the end of the year.

“Monetary policy works with lags before it fully kicks in,” he said. He said if the Fed was still having to go further by the end of the year recession would look more likely.

“If inflation is coming down steadily they may pause, but if inflation is not coming down it will go for a while longer.”

Once inflation is back under control the growth scenario will be no different to what it was before the pandemic.  If inflation doesn’t come under control it will lead to higher nominal interest rates with an impact on portfolios, particularly affecting organisations with highly levered balance sheets. He warned of toxic consequences if high levels of leverage combine with asset declines.

“The increase in leverage in the last few years is something to worry about.”

He said the aging labour force makes immigration increasingly compelling, and a positive force. He also noted how climate change is increasingly feeding into immigration trends. Rajan concluded that climate change is an opportunity for investors and policy consensus is essential to drive investment.

In a panel session at the Fiduciary Investors Symposium at Chicago Booth School of Business, Stephen Kotkin, The John P Birkelund Professor in History and International Affairs, Princeton University, cited the many risks inherent in investing in China.

Kotkin explained that Europe and China’s trade partnership has been damaged by a souring relationship. A trade deal negotiated ahead of Biden assuming the US presidency has floundered and since Russia invaded Ukraine, relations have grown worse still. “Xi is siding with Putin and pushing Europe into the arms of the US,” said Kotkin. In so doing, China has destroyed the wedge it had opened and today Europe and the US are strongly aligned on China policy.

Investing in China holds key challenges for investors. Demography will crimp economic growth and China remains in the middle-income trap. Countries find it hard to rise from middle-income to high-income and success depends on a strong, broad-based education system. China has only developed a high-end education system in its capital cities, leaving hundreds and millions of people without an education. Kotkin said China has begun to invest in its schools at a regional level, but these vocational schools lack qualified teachers.

Kotkin said investment no longer has the ability to shift the Chinese economy to a consumption driven economic model supported by local consumer demand. “The high investment model has hit a wall,” he said. Moreover, China will not solve its problem via governance.

The communist party has clamped down on the private sector. Liberalization threatens the communist system, beginning a process that questions the monopoly of the party. Although the party could reform economically and allow the private sector to flourish, independent sources of wealth and power threaten the Communist system.

He noted how the government is trying to encourage private sector growth at a low level, supporting small entrepreneurs. Kotkin referred to economic growth in China as an output not an input: the party says what it will achieve – and if it doesn’t achieve it, the regime lies.

Kotkin added that it is difficult for ESG investors to invest in China. Chinese policy towards the Uyghur population in the north-western region of Xinjiang, Tibet, Taiwan and Hong Kong doesn’t sit easily with ESG investment. Regarding Taiwan, Kotkin said that the status quo is tipping away from China given the majority of Taiwanese no longer identify as Chinese in a shift accelerated by the younger generation. He noted that China’s strategy is to integrate Taiwan economically to gain political integration. China’s strategy will focus on economic coercion, and the regime is watching how the west is applying economic pressure on Russia.

He noted that the Chinese regime will “not wait for ever” as Taiwan moves further away from China in its identity and politics.

Kotkin said that even if some of these assumptions are incorrect, investor returns in China do not equate to the risk. “Are you satisfied that the risk premium is good enough?” he asked delegates.

He noted how investors and companies are starting to move in multiple directions. Some investors see China as a one-way bet; a story of high returns and growth while financial firms are tempted by the level of savings in China. However, he noted how an increasing number of firms are diversifying their supply chain away from China. Some companies, like Apple, are particularly vulnerable to China. “If China stops working, Apple goes up in smoke,” he said.

FIS delegates reflected that they have more confidence in private-sector investment in China than public sector investment. Elsewhere, others argued that owning Chinese government bonds could be an effective and lower risk strategy to gain exposure to Chinese growth – but would require living with the ESG risk. “You could buy bonds if you can keep quiet,” said Kotkin.

Elsewhere delegates discussed the idea that China will ultimately emerge from the middle-income trap. In this way, buy-and-hold strategies could work in an approach structured to benefit over the long term. In this approach, investors should remain humble, remembering the Fed has also got it wrong. In another approach delegates talked of the importance of engaging. For example, the PRI has worked with Chinese companies involved in BRI construction.

Ukraine

Turning the conversation to Ukraine, Kotkin articulated the challenges that lie in the way of a Ukrainian victory.  Russia has a stranglehold on the economy, leaving Ukraine with no government revenue to meet its payroll commitments while the current aid packages will soon run out. “The stranglehold on the Ukrainian economy will be expensive for western taxpayers,” he said.

Russian troops will have to be evicted, yet evicting Russian troops involves going on the offensive, requiring new skills in the army. He said it could become apparent in July and August if the Ukrainians are able to go on the counter offensive.

Moreover, Western unity is fragile. For example, Hungary has not agreed to the recent oil embargo; Turkey has thrown a spanner in the works of Finland and Sweden’s plans to join NATO. Lastly, Kotkin noted that sanctions have consolidated the Putin regime. Still, the most effective sanction is technology export controls, slowly strangling Russia’s ability to access software vital for its military industrial complex.

 

 

The private credit market is starting a new sixth cycle, said Victor Khosla, founder, SVP Global, which manages around $18 billion across the asset class. Khosla said key factors that suggest the market is in the early stages of another cycle include high yield spreads widening over treasuries and the fall in equity markets.

It has led to the emergence of opportunities in selective areas, with the expectation that more will start to appear in the next three to six months. The size of the opportunities will depend on whether the economy enters a full-blown recession or not: if this cycle bites, and Khosla believes there is a fair chance it will, he expects an 18–24-month recovery.

In a reflection of the growth in the number of deals coming across the desks of SVP’s 65-person team, he said experts are now working on around 55 deals, up from 13 in January 2022.

Recent deals reflect specific characteristics of the current economic climate. For example, earlier this year SVP bought Associated Materials, a building products company and a market leader in vinyl windows, vinyl cladding, and metal siding and trim. Hit by higher raw material costs, the business failed to respond in time by raising its own prices; cash flows fell, and the owners got anxious. “We stepped in to buy the business,” said Khosla. Now SVP Global is working with the company to drive change, building a new source of value creation. “We can see the early fruits,” he said. Describing the acquisition as an attractive control investment, he expects similar opportunities ahead given the economic environment.

European opportunity

Khosla believes Europe may hold the most compelling opportunities in private credit in the coming months. Many European economies were weak before the pandemic and the European banking system is still laden with debt. He cited estimates of over €1 trillion of bad debt sitting on European bank balance sheets by the end of 2022 – much less than the debt on the balance sheets of US banks. “We expect Europe to hurt more in this cycle,” he said.

Although Khosla said opportunities are unlikely to focus on specific sectors, he noted that industrialised businesses subject to inflation in raw materials (like Associated Materials) might suffer more than others and run into problems with liquidity. “Some business can pass through price rises, but many can’t.” He noted how some power generation businesses are struggling and said that real estate is also going through a correction that will take a few years to play out.

SVP is distinct from rival investors specialising in private credit because around 30 per cent of its capital is invested in control deals whereby the manager takes a majority equity control of the business, directly getting involved in fixing and improving the company. This element of control makes SVP’s investments less cycle dependent and more evergreen. Indeed, some of SVP’s best historic returns haven’t come as part of a private credit cycle. When SVP Global is a majority equity owner it is also easier to push through ESG criteria, he said.

Late Exit

Another key characteristic of today’s market is difficult exits: challenging market conditions are delaying exits and monetization. Khosla said that SVP owns businesses today that are ready to exit, and if markets were stable, these businesses would be sold. “We are not selling; we are pulling back.” Khosla concluded that SVP has made progress hiring a more diverse workforce, recruiting more women and minorities. “The way we recruit has changed,” he said.